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Monday, September 6, 2010

The relationship between financiers and entrepreneurs harms capital allocation, innovation, and entrepreneurial success is the longer title. I dislike using the word capitalism because it is ephemeral, and without common meeting, and has practical corruptions that differ from its theoretical purities. Capitalism harms or is anti capitalism becomes a sensible sentence.

Common shares determine ownership in a corporation. Both in terms of voting power, and share of distributions (dividends or proceeds from sale of corporation). They have the same failing as general democratic institutions in that a majority shareholder or majority forming cartel obtains decision authority over the corporation. The basis that all shareholders must be paid equally if they are paid is insufficient to ensure that majority decisions benefit all shareholders. Entrepreneurs, managers and Financiers have different general objectives. The financier wants to be paid back. Entrepreneurs would tend to have grander vision and aspirations of empire than managers, but both seek employment benefits.

Corporate governance is on its face, a board of directors appointed by shareholders to monitor management's duty to maximize shareholder value. In practice, for public corporations, management is very influential, often naming all board members with the president as chairman. This occurs because most investors find it easier to sell their shares than to seek control of the board or fire management. There is no widespread motivation to expose stock ownership as a scam since financiers need other gullible financiers in order to divest. Hope and greed that delusions of stock value persist, prolongs the cycle of further financier participation in the scam. We invent the matrix, and reinforce it.

The major conflicts that occur between management sympathetic directors and non controlling shareholders are reinvesting surpluses (into for example buying other companies) instead of paying dividends, and diluting investors by issuing more shares (many to employees). Proof that buy and hold shareholder strategy fails is that The average large corporation lasts 40 years before bankruptcy, and dividend payouts rarely compare to bond payments (which include repayment of principal at end of term). The only genuine hope for corporate investor returns is through a takeover. Both bankruptcies and takeovers are quite cyclical, but bankruptcies outnumber takeovers in both value and instances. If buy and hold is foolish for 100 years, then it is necessarily foolish for 5 or 20 years. Insiders, professionals, and stock promoters can sometimes make money by selling prior to collapse, but it is at the expense of foolish passive investors, and either through corruption or luck. Proof that management of public companies control shareholders rather than perform their facial duty is they do not pay very high dividends with the confidence that shareholders will reinvest into the company.

For private corporations, companies who have yet to grow enough to become public or entrepreneurial startups, shareholder financiers need majority control, because they don't have the option of secession present in public ownership (they cannot easily sell shares) if they are dissatisfied. Because of the ease of selling/secession and no duty to monitor management, most financiers prefer investing in public corporations despite it being a scam. Entrepreneurs have difficulty finding financing for projects, because there are few willing financiers who fear the pitfalls of public company investing, and they need to insist on a high majority (controlling) share, which is unappealing to entrepreneurs.

Entrepreneurial funding is time consuming. There is imperfect competition in that the first investor that shows interest is likely to be able to dictate terms. Just as poor people are more likely to fail due to the high interest of sub-prime loans, ventures with too little return for effort are more likely to be abandoned by entrepreneurs.

Traditional debt financing has problems as well for both investors and entrepreneurs. For investors and entrepreneurs, other and future debt, or shareholder dividends, makes the security of the debt completely unknown, and so pricing of the debt either must approach worse case scenarios, or be unfair to the lenders in the event of present or future management substantially increasing leverage. Debt financing further tends to be limited to company asset value.

Real innovation depends on startups and private companies. Public companies that survive often do so by blocking innovation through barriers to entry, or often through the only known free market: the market for politicians. The artificial attractiveness of public corporate funding hurts the financing available for startups and private corporations, and thus hurts innovation and entrepreneurship: capitalism harming innovation/capitalism.

This post has mostly been addressing the principal-agent problem. Agents (management) have their own agenda despite a pretense of duty to Principals (shareholders). It's a pervasive social problem, and present in all agency relationships.

Natural finance solves the principal agent problem by making management/labour the only encouraged shareholders, and therefore a principal only relationship. Financiers are paid first, and as quickly as possible. Individual financier investments have a known value proposition (far easier to evaluate than common share proposition) at the time of investment, and can never be diluted. By providing entrepreneurial control and freedom, the necessary motivational drive for successful innovation is present.

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